Why Are Chesapeake Energy’s Production Costs Falling?

The elevated price of natural gas has improved the bottom line for oil and gas producer Chesapeake Energy (NYSE: CHK) . But the rising price of natural gas has eclipsed the company's steady improvement in its operations. In order to demonstrate the shift in efficiency, let's take a closer look at two of the company's top assets, which account for nearly a quarter of its production: the Haynesville and Eagle Ford shales.

Fewer wellsChesapeake Energy showed a sharp improvement in the present value of its oil and gas revenue (PV-10). Eighty-five percent of its wells were profitable in the first quarter of 2014 compared to only 46% back in 2012. This improvement was partly due to reduced costs and a shift from less profitable wells to more lucrative opportunities. Furthermore, the company lowered the number of completed wells; case in point, in the first quarter of 2014, it completed 234 wells compared to 274 wells in the same quarter last year and 1,388 during 2013. The company plans to reach 1,200 this year.

In order to reduce costs, the company has updated its asset-divestment program, which includes the sale of non-core assets in Southwestern Oklahoma, East Texas, and South Texas. But besides selling assets, Chesapeake Energy has also shifted its operations toward more profitable assets.

Haynesville shaleThis region is less profitable than other regions, as it primarily produces natural gas. In recent months, the recovery of natural gas has made this region's output more profitable, but over the long run, the company is expected to cut its production in this region. In the first quarter alone, Chesapeake slashed this region's production by 41% to 495 million cubic feet of natural gas equivalent, year over year. Here is a way to demonstrate why the Haynesville shale is less profitable than other regions:

The chart above compares the average well cost (in millions) of the Eagle Ford shale and the Haynesville shale.

As you can see, the Eagle Ford region offers much lower costs. Moreover, the Eagle Ford shale has a big portion in oil operations, which are likely to be more profitable over the long run.

Other natural gas producers have also backed out from the Haynesville shale region: According to the Energy Information Administration, Haynesville's number of rigs dropped to around 50 in 2014 -- back in 2010 it was close to 250 rigs. Furthermore, natural gas production has also declined in recent years.

Eagle Ford shaleThis region has been heating up in the past several years as more oil producers have entered the location, including Devon Energy (NYSE: DVN) . Back in February, the company closed a $6 billion deal to purchase acreage in the Eagle Ford from GeoSouthern. Some analysts estimate the Eagle Ford's production could rise to 2 million barrels per day by 2020 -- currently the production is around 1.4 million barrels per day.

As stated earlier, this region holds not only natural gas but also oil. For Chesapeake Energy's Eagle Ford shale operations, oil production accounts for 64% of the mix, while natural gas holds only 21% in this mix. The rest (15%) is NGL, or natural gas liquids.

Despite the total decline in the number of completed wells, as presented earlier, the company has increased the number of producing wells in the Eagle Ford shale from 650 in the first quarter of last year to 945 wells by the end of March -- a 45% spike. Furthermore, the Eagle Ford's net production averaged approximately 88,000 barrels of oil equivalent per day compared to 75,000 boe per day -- a 17% rise year over year. Adjusting for Chesapeake Energy's asset sales, its production grew by 26% in this region.

In order to further increase this growing and lucrative region, the company plans to allocate 39% of its capital expenditures toward expanding its operations in this region. In comparison, Chesapeake Energy will allocate only 8% of its capex to the Haynesville shale.

In conclusion...Chesapeake Energy has made changes in its asset portfolio and plans to further increase its production in more profitable regions such as the Eagle Ford shale. These steps will keep improve the company's bottom line even if oil and natural gas prices change direction and start to drop.

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